Detecting Informed Trading Risk from Undercutting Activity in Limit Order Markets

Abstract

Abnormal undercutting activity (QIDRes) captures informed trading risk as liquidity-providing algorithms compete less to fill marketable orders when adverse selection exposure rises. Unlike existing measures of informed trading risk, daily/intradaily QIDRes is easily constructed for any security with trade and quote data and is uncorrelated with liquidity. When examined around information events, QIDRes behaves similarly to existing measures and predicts arrivals of imminent information events. Moreover, higher QIDRes coincides with weaker subsequent price reversals and increased short-seller and informed institutional-investor activity. Further, QIDRes predicts daily and monthly stock returns, which we attribute to limits-to-arbitrage and informed investors’ order type choices.

Keywords: Informed Trading, Undercutting, Asset Pricing, Liquidity, Limits to Arbitrage

JEL Classification: G14